Add Startups to balance your portfolio, if you dare

by root shed

Investing in entrepreneurs and startups is a fun but different world from investing in conventional stocks, bonds, and commodities. First of all, it’s more of an investment in people than in a business, since the startup is usually an idea barely half-baked when they need your money. Secondly, the risk is very high, since as many as 90% of startups fail in the first five years.

On the plus side, it’s an opportunity to get in early and really help make things happen that will change an industry, or change the world. It’s an opportunity for that ‘big bang’ return of 10X to 100 times your initial investment, like early investors in Google, Microsoft, and Apple. Finally, it’s an opportunity to ‘give back’ what you have learned in your own career for the next generation.

Today you still need to be registered with the SEC as an ‘accredited’ investor to legally buy any startup equity. This requires a simple signature that you have a net worth of at least $1M or have made at least $200K each year for the last two years. But these requirements go away with the new Crowdfunding JOBS Act just passed into law.

With all these considerations, I recommend the following steps and considerations for investors newly interested in startups:

Build a balanced investment portfolio. Just like a seasoned stock investor would never put all his investible resources into a single stock, don’t put all your money into startups. Begin with perhaps 5-10% of your total investment base, and be prepared to lose it all. The growth target should be 5-10 times your initial investment in five years.

Start in a business domain you know well. Since there are no bellwethers like Apple or IBM in the startup arena, your best bet is to pick one in a business area you know well. Don’t be fooled by thinking that social networks are hot, so you should invest in the next startup you see in that realm. Remember that 9 out of 10 startups fail in every realm.

Fund an entrepreneur you know and trust. In the business, this is called investing at the first tier for startups – ‘Friends, Family, and Fools (FFF).’ Most entrepreneurs start asking for money from this tier, when they have very little more than an idea. Here you are definitely betting on the person, rather than the idea, but the upside potential is huge.

Join an existing Angel investor group. This is the second tier of startup investors, and offers the comfort of working with more experienced investors with similar interests, to help gather and vet startup investment proposals. Some of these groups also offer you the option of putting your money into a multiple-startup fund to spread your risk.

Diversify your total investment across several startups. Angel investment amounts per startup per investor usually range from $25K to $250K. These may be aggregated by an Angel group up to about $1M for an Angel round. If a startup needs more than this in a single round, they should talk to venture capitalists, who invest institutional money rather than their own personal money.

Use the new Crowdfunding sites for small amounts. The hottest new way of investing in startups to go to popular online sites like Kickstarter and IndieGoGo. There you can get in for as little as $20, or even less. Today these are only legal in the USA for non-equity rewards or pre-orders, but the JOBS Act will relax the accredited investor rule by early 2013.

Participate as a mentor in local startup incubators. Incubators are a great place to learn about potentially great startups, and participating as a mentor helps you learn which ones are a good fit for you. The best known ones, like YCombinator, led by Paul Graham in Silicon Valley, and TechStars, located in Boston, provide excellent networking to investors, and on-site technical leadership, which can make your investment less risky.

Do your homework before investing. Public companies with stock usually have industry analysts and SEC filings to give investors a quick view of the company stock value. Startups are private companies with no common document filing requirements. Thus it is incumbent on every potential startup investor to ask for and read their business plans, current financial statements, and investor presentations.

Invest local and take an active role. Most Angel investors only invest in companies and people local to their geography. Skip international and other opportunities you can’t touch and feel. Many negotiate a Board Seat for themselves as part of the investment Term Sheet. This allows them to ask for and get regular updates from the company, and allows them to have a say on how their money is used.

Think long-term. It’s a lot easier to buy stock in a startup than it is to sell it. Once invested, you should expect no return until the first ‘liquidity’ event in 3-5 years, maybe longer. Liquidity events include merger or acquisition (M&A), or Initial Public Offering (IPO) when the stock goes public. There is no ‘exchange,’ so you can’t sell the stock at will.

In summary, investing in startups can be very rewarding, both financially, and in your ability to really help someone who needs help. But it’s always a risky proposition, probably well beyond the risk of the commodities market, since there are so many unknowns and few controls.

My advice to new startup investors is to start slowly, stick to business areas that you know well, and put more weight on your assessment of the entrepreneur and the team, than on the idea. Successful startups are all about the execution. You don’t want to end up on the wrong side of that equation, but you do want a bite of the next Apple.